Risk Management and Transparency

in the Construction and Monitoring

of a Fund of Hedge Funds Portfolio
December 1st, 2005

Dr. Lars Jaeger, Partners Group, Zug

Summary:

This paper presents a discussion about the various aspects of meeting the
challenge of active and independent risk management in portfolios of
Hedge funds. It will be illustrated that Hedge fund risk management
cannot be discussed in isolation with the topics of transparency and
liquidity. The article further elaborates in detail on appropriate risk
measures for hedge fund portfolios and finally sheds light on a scheme to
embed risk management entire hedge fund investment process.

Partners Group
Zugerstrasse 57
6341 Zug
Switzerland
Phone +41 (0)41 768 85 02
lars.jaeger@partnersgroup.net
www.partnersgroup.net

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I. Challenges for the Hedge Fund industry
Recent years have seen unparalleled capital inflows into Alternative
Investment Strategies, i.e. Hedge funds, which have provided this
industry with a tenfold increase of assets in the last twelve years.
Investors in Hedge funds now stretch beyond the selected group of high
net worth individuals that have traditionally made up the large majority of
investors. The widespread interest in hedge funds can be attributed to
their attractive risk-reward characteristics and their low correlation to
traditional asset classes1.

However despite increasing mainstream popularity, the hedge fund

industry must address two important challenges in order to continue its
impressive growth—first generate absolute returns in challenging market
conditions, and secondly introduce reliable independent risk management.

1. Falling Returns Lead to Rising Investor Scrutiny The surge in

capital flows to hedge funds and increase in institutional investment come
as hedge fund managers have provided on average rather mediocre
returns which are significantly below their historical mean. The five-year
period from 2000 to 2005 characterize the weakest performance in the
history of hedge funds. Falling hedge fund returns lead investors to ask
about their return sources and risk exposures, before allocating capital to
them. In other words, if the black box does not deliver anymore, investors
request a look inside. Despite the claim of market-neutrality, hedge fund
strategies as a group have clearly not escaped the downward pull of falling
stock markets. Lacking the “beta tail wind” of the bull markets in the
1990s many hedge funds have yet to prove themselves as real “alpha
generators”. While this article focuses on risk management rather than
returns, the two are directly related.

Two short remarks are necessary: First, one should note that the
statement about weak hedge fund performance applies to the absolute
level of performance, the only measure of performance that hedge funds
(according to their own claims) should be measured by. On a relative
basis, though, hedge funds outperformed stocks by as much as never
before having escaped the large losses of equity markets in 2000-2003.
Secondly, although the Hedge fund industry has fallen short of keeping
their return promise in recent years, the industry has kept the “low risk”
promise. Despite extremely high volatilities in global financial markets
volatility of Hedge funds has remained rather limited: A diversified Hedge
fund portfolio usually displayed volatilities of around 5-8% (however,

1
See Jaeger, L., “The Benefits of Alternative Investment Strategies In the Global Investment
Portfolio,” Partners Group Research, Jan. 2003, available on Partners Group web page:
http://www.partnersgroup.net.

2
individual hedge funds have shown significantly larger fluctuation,
including the total loss of capital).

2. The Need for Risk Management: Investors are also more and more
concerned about the diverse risks of hedge funds investments unknown to
them. This risk is aggravated in the minds of investors by the lack of
independent risk management, low transparency, and limited liquidity (i.e.
long redemption periods), which still characterize most hedge funds today.
Many potential investors continue to view hedge funds as too mysterious,
secretive, and hard to get in and out of—a blind jump into a dark tunnel of
indefinite length, with few exits. While for years certain types investors
accepted followed a “black box” investing approach (i.e. investing in non-
transparent and illiquid funds) and accepted long redemption periods in
exchange for attractive returns, this approach is now harder to sell.
Increased interest from institutional investors has led to new demands for
disclosure, more clearly defined risk profiles, independent third party risk
management, greater transparency about performance attribution and
higher liquidity due to the fiduciary responsibilities associated with
investing clients’ money2. Further, several widely publicized hedge fund
failures during the market crisis of 1994 (e.g. Askin) and 1998 (e.g.
LTCM) and periodic reports of other hedge fund “blow ups” and fraud (e.g.
“Manhattan Fund” in the spring of 2000, “Beacon” Hill in the fall of 2002,
“Bayou” in 2005) have added to investor concerns about the
“extraordinary event risks” of their hedge fund investments. Finally, rapid
developments in financial risk management have made risk analysis for
even complex hedge fund portfolios feasible in near real-time. When such
analysis and risk management is possible, investor expect that it should
be done.

These trends illustrate a trend in investors’ attitudes changing from

accepting (“trust me”) to demanding (“show me”). As a result, the Hedge
fund industry is currently going through an institutionalization process,
where Hedge Fund managers are increasingly faced with demands for
increased investment transparency, independent third party risk
management, higher liquidity (i.e. shorter redemptions periods) and
greater clarity in terms of portfolio composition, strategy details,
performance and fee attributions, and leverage. A new class of fiduciary
investors has put these issues at the top of its priority list.

Peter Bernstein, in his classic book Against the Gods3, introduces the
mastery of risk as ‘the revolutionary idea that defines the boundary

2
See also the Survey conducted by the Barra Strategic Consulting group in 2001, published in “Fund
of hedge funds – Rethinking resource requirements”, Barra Group, September 2001
3
Peter Bernstein, Against the Gods – The remarkable story of risk, New York, Wiley, 1996.

3
between modern times and the past’. Bernstein tells a remarkable story
on the evolution of perspectives on risks through the last two and a half
millenniums and concludes:

“Cardano the Renaissance gambler followed by Pascal the geometer

and Fermat the lawyer, the monks of Port Royal and the ministers of
Newington, the notions man and the man with the sprained brain,
Daniel Bernoulli and his uncle Jacob, secretive Gauss and voluble
Quetelet, von Neumann the playful and Morgenstern the ponderous,
the religious de Moivre and the agnostic Knight, pithy Black and
loquacious Scholes, Kenneth Arrow and Harry Markowitz – all of
them have transformed the perception of risk from chance of loss
into opportunity for gain, from FATE and ORIGINAL DESIGN to
sophisticated, probability-based forecasts of the future, and from
helplessness to choice.”

His history concludes in 1995. I believe that hedge funds merit another,
maybe final, chapter in his book, which would tell us about the shift from
relative to absolute returns (and risk) in investing, the skilful exploitation
of risk premia across financial markets by the most talented investors on
Wall Street, and the latest about market inefficiencies and ’irrationality’
exploited by hedge fund managers. It would also tell us about new choices
investors are able to make, rather than helplessly being exposed to the
forces of financial markets. It would finally tell us about the constantly
changing dynamics of the many hidden risks financial markets display and
of which investors must be aware.

II. Sources of Hedge fund Return

Financial textbooks state that return and risk of investments are directly
related. The level of systematic (i.e. non-diversifiable) risk of a financial
asset determines its return. An elaboration about hedge fund risks and
risk management can therefore not be completed without mentioning a
few words on their return sources. The understanding of hedge fund
return sources in connection with systematic risks is an essential tool for
appropriate diversification in the hedge fund portfolio and risk
management.

There is a widespread belief that hedge funds earn their returns solely
through the identification of market “inefficiencies” not recognized by
other market participants. This creates some confusion and skepticism
among investors, as the markets hedge funds operate in markets which
are not considered to display inefficiencies large enough to provide such
attractive return profiles (Wall Street does not very often offer “free
lunches”). A significant part of the confusion arises from the inability of
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conventional risk measures and asset pricing theories to properly measure
the diverse risk factors and return sources of hedge funds. It is important
to realize that hedge funds managers are largely exposed to a variety of
different systematic risks4 and thus earn corresponding risk premia as a
significant part of their return profile (asset pricing theory links these
returns to “betas”). Many hedge fund investors often lack an
understanding of the fundamental difference between managers providing
returns through an informational advantage or applying a certain
investment skill to exploit market inefficiencies (“alpha”) and a manager
generating returns by assuming systematic risks and earning
corresponding risk premia (“beta”).

However, at the same time we are starting to realize that hedge fund beta
is different from traditional beta. While both are the result of exposures to
systematic risks in the global capital markets hedge fund beta is more
complex than traditional beta. Some investors can live with a rather
simple but illustrative scheme suggested by C. Asness5: If the specific
return is available only to a handful investors and the scheme of
extracting it cannot be simply specified by a systematic process, then it is
most likely real alpha. If it can be specified in a systematic way, but it
involves non-conventional techniques such as short selling, leverage and
the use of derivatives (techniques which are often used to specifically
characterize hedge funds), then it is possibly beta, however in an
alternative form, which we will refer to as “alternative beta”. In the hedge
fund industry “alternative beta” is often sold as alpha, but is not real alpha
as defined here (and elsewhere). If finally extracting the returns does not
require any of these special “hedge fund techniques” but rather “long only
investing”, then it is “traditional beta”.

The statement that risk premia are a dominant source of hedge fund
returns does by no means imply that manager skill is not essential or even
meaningless. Manager skill and the direct exploitation of market
inefficiencies are important return sources for hedge funds. The
implementation of a particular trading approach can be quite complex and
difficult and often requires a rather unique skill set and “edge” on the side
of the manager. It is the experience and creativeness of the single hedge
fund managers related to the complexity of the traded instruments, the
nuances of the hedging process, the daily trade execution, and, last but
not least, the details of the risk management process (avoiding/hedging
certain risks and consciously taking other risks) that enable him to create

4
As the reader surely remembers form finance textbooks, systematic risks are those risks, which
cannot be diversified away by investors. The corresponding returns are economic risk premia which
are the result of imperfect risk sharing among different investors in financial markets.
5
C. Asness, “An Alternative Future, I & II” Journal of Portfolio Management (October 2004).

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real value to investors. Be it through the smart capturing of risk premia or
through the direct exploitation of market inefficiencies.

Many investors believe that investing in hedge funds revolves around the
search of alpha (and the quest for capacity with the perceived star
managers). The author believes that the search of alpha must begin by
understanding beta, i.e. the assessment of systematic risk factors (going
beyond the equity markets’ beta). Perceived price anomalies and apparent
arbitrage opportunities are often related to risks and corresponding risk
premiums. The sources of hedge fund return and some of the implications
of the increasing recognition in the hedge fund industry that their returns
stem more from risk premia than form the exploitation of market
inefficiencies are discussed in more detail in a recent publication of the
author6. The comprehension about return sources and risk factors are vital
element of hedge fund investing and risk management.

III. Special Challenges of Hedge Fund Risk Management

But if independent hedge fund risk management is so important and in

such current demand, why is it still the exception rather than the rule?
Because hedge fund risk management presents two unique challenges:
complexity and rapid change. Hedge fund strategies are much more
complex and varied than traditional asset classes. They partake of all of
the complexity of the traded markets, plus an meta-layer of complexity of
their own. Yet these strategies are changing even as investment
professionals and risk managers struggle to understand them. To make
matters worse, the overall risk management practices of the investment
community are also rapidly changing across all asset classes. However,
there is hope. The “state of the art” in financial risk management has
developed dramatically over the past few years, with new paradigms and
ever more complex models continuing to emerge. While confusing to some
investors these new tools create new opportunities to monitor and “fine
tune” risks in hedge funds much more accurately than just a few years
ago.

Further challenges for hedge fund risk management are their low visibility
and limited liquidity. Hedge funds have traditionally been reluctant to
disclose details about their trading strategies and market exposure and
have imposed extended redemption periods (“lock ups”) on the investor.
However, the request for independent risk management has important
implications for transparency and liquidity. It is undisputed that

6
L. Jaeger, C. Wagner “Factor Modeling and Benchmarking of Hedge Funds: Can passive investments
in hedge fund strategies deliver?”, Journal of Alternative Investment (Winter 2005).

6
transparency to the level of knowledge about trading positions is a pre-
requisite for solid risk analysis. Further, the possibility to act on sufficient
liquidity is a necessary requirement for active risk management. Clearly,
the traditional lack of transparency and long redemption periods with
single hedge fund managers present serious problems to the risk
manager. Monthly returns, standard deviations, maximal draw-downs and,
in most cases, a monthly or quarterly letter to the investors, just do not
provide sufficient information for his purpose.

The discussion within the hedge fund industry about how to address these
issues is in its early stages. At the center of this discussion lies the
challenge of eliminating undesired risks while reaping the benefits of
hedge funds. With the advent of a higher degree of sophistication in hedge
fund portfolio management by institutional investors and fund of funds,
solution to these problems have started to emerge, which will be
discussed later in this article.

IV. Risks in Hedge Funds

Hedge fund risks compared to the risks of traditional investments

The discussion on risk management has to start with a definition of risk.

There is an important difference between hedge funds and traditional
investments in how risk is defined. Hedge fund managers define risk as
total risk whereas most traditional equity and bond (long-only) managers
measure risk relative to a benchmark (and measure it correspondingly by
the so called “tracking error”). Thus the latter defines risk as only the
“active risk” element in the portfolio7. Note that the exclusion of the
“passive risk” (i.e. the “beta risk” of the broad market) in a risk measure
leaves the largest risk source in a traditional portfolio unconsidered. The
end investor’s definition of risk is total risk as this is what determines the
level of his wealth. The traditional manager has no incentive (neither any
means) to manage the passive risk. It is effective “managed” (i.e.
determined) by the market itself.

7
Risk measured against a benchmark can yield to the counterintuitive effect that an increase of the
cash allocation in a portfolio at the expense of a lower stock allocation can lead to a higher risk in the
portfolio. A traditional “relative” money manager’s first goal is to not perform worse than the
benchmark, even when the benchmark looses 50%.

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In contrast, the hedge fund manager has strong incentives to keep the
total risk of the investment under control. Because of a hedge fund’s focus
on absolute returns the first priority of the manager is capital
preservation. Hedge funds make consistency and stability of absolute
returns, rather than magnitude, their key priorities. The hedge fund
manager follows strict risk controls and concentrates on very particular
risks, which he understands, with which he has good experience, and for
which he has a unique skill set. Unwanted and uncontrolled risk (e.g.
broad equity market risk) he often actively hedges away. Many consider
the name “hedge” fund a misnomer, as many hedge funds are leveraged
rather than hedged. But the hedging of unwanted risk in most hedge
funds actually gives the name “hedge fund” a valid justification. Managing
hedge funds has at least as much to do with risk management as with
picking stocks or timing a particular market. Good hedge fund managers
are today among the best risk managers on Wall Street.

An important consideration for hedge funds relates to the statistical

measurement of risk. Numerous hedge fund strategies – such as short
option strategies - have non-symmetric (negatively skewed) return
distributions and leptokurtic (i.e. fat-tailed) return distributions (see some
quantitative results in the next section below). In these cases, the
conventional measure of risk, namely standard deviation, is insufficient for
risk measurement. Investors usually have a preference for positively
skewed outcomes and an aversion against negatively skewed and fat-
tailed outcomes. This is not captured by a risk measure like the standard
deviation that weighs each parts of the distribution identically and does
not display a sufficiently high probability to extreme events. One should
therefore be cautious when using the standard mean variance
optimization approach when hedge funds are part of the investment
portfolio. The appropriate choice of a risk measure is essential for the
management of hedge fund portfolios.

One can argue that the higher risk adjusted returns for hedge funds
(when measured by mean and variance) are partly a compensation (risk
premium) for higher tail risk, i.e. leptokurtosis, and the relatively higher
probability of very low returns than very high returns, i.e. negative skew.

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Market risk and Manager risk

Hedge fund investors have to deal with two main categories of risk:

1. Style (or “strategy”) Risk – This risk is also known as “systematic

risk”. It is related to each strategy sector (or “style”) and describes
the a priori known risk of potential market behaviors affecting the
entire strategy sector adversely, e.g. equity market (directional) risk
for long biased Long/Short Equity, credit spread risk or equity
market volatility risk for Convertible Arbitrage. Style risk can be a
complex combination of market risk (risk arising from changes in
the market price of financial assets), credit risk (risk of that a
counterparty does not meet or is expected to not meet its
contractual obligations), or liquidity risk (inability to execute
transactions or unexpected decrease of funding opportunities)8. As
discussed above the (systematic) style risks of the individual
strategy sector are essential return generators of most hedge fund
strategies. Therefore, taking a certain amount of these risks is a
prerequisite for hedge fund performance.
2. Manager specific (“Structural” or “Operational”) Risks – These are
the risks related to the possibility that the specific manager
experiences a large unexpected loss related to certain risks unique
to the manager such as style drifts, operational problems,
concentration in individual securities, fraud, business risks (e.g. key
people leaving), etc. Manager specific risk is unsystematic, i.e. it
does reward investors with an expected return.

Strategy or portfolio risk is best dealt with through appropriate

diversification among various strategy sectors. This requires precise
knowledge of those including their return sources, dependence structure
and their behavior in favorable and unfavorable market environments. A
diversified hedge fund portfolio contains strategies, which have their
strengths and weaknesses in different market environments.

There are different views on how to achieve sufficient protection against

manager risk. Some hedge fund investors follow the approach of selecting
several dozen different managers, thus limiting the impact of a single
manager blow-up in their portfolio. This approach is often sub-optimal as
it leads to efficiency losses resulting in more required manager due
diligences, less time spent per manager, and over-diversification. The
outcome is often mediocre performance and undesired high correlation to
equity markets. Recent research indicates that one can build a well-

8
See L. Jaeger “Risk Management in Alternative Investment Strategies”, Financial Times-Prentice
Hall (2002), for more details on these systematic risk factors.

9
diversified portfolio with 15 to 20 managers9. Active post-investment risk
management can decrease manager risk dramatically, and thus the
number of managers needed for appropriate diversification.

A further note on strategy versus manager risk: It has become standard

notation in the broad investment industry and literature to refer to these
two risk types as “systematic” and “unsystematic” risk. It is important for
the risk manager to distinguish these two risk types, and specifically
measure them independently. While it has become a standard procedure
in the traditional investment realm the distinction is by far not standard
for the hedge fund risk manager, mostly because this distinction has so
far not been widely made. The recognition of systemic risks (and thus
return drivers) in a hedge fund portfolio is quite new. This touches directly
on the topic discussed in section II above. In order to distinguish the
systematic risk factors form the manager specific idiosyncratic risk, we
need a model to identify the former. There has been tremendous progress
in the academic research concerning this topic, to which we refer the
reader at this point.10

The scaling of risk: Leverage

Leverage is a way to scale risk and return proportionally, and, on a

standalone basis, it is not a very useful measure of risk. High leverage
factors do not necessarily imply unacceptably high risk. However, in
investors’ perception excessive leverage is widely considered on the main
risk factors of hedge funds (especially after the fall of LTCM, an
exceptionally highly leveraged hedge fund). It remains often unmentioned
that most hedge funds employ rather limited degrees of leverage. A
recent survey revealed that 77% of the hedge funds employ a leverage of
less than two (i.e. less than 100% borrowed foreign capital)11. Leverage is
not always undesirable and, in certain instances, can be helpful to achieve
the desired risk-return profile of a strategy. But leverage bears additional
specific risks. Asset liquidity, leverage and financing risk are inter-related
and cannot be assessed in isolation. When instrument liquidity evaporates
(e.g. in market stress situations), counterparties, usually consisting of
prime brokers as providers of leverage financing, can quickly withdraw

9
Interesting studies about how many managers are needed to reach sufficient “manager
diversification” in an AIS portfolio are presented in “The Benefits of Hedge Funds” by T. Schneeweiss
and G. Martin, Lehman Brothers Publications (August 2000). See also a new study by S. Lhabitant
and M. Learned, “Hedge Fund Diversification: How much is enough?” Journal of Alternative
Investment (Winter 2002)
10
See the recent publication by the author and references therein: L. Jaeger, C. Wagner “Factor
Modeling and Benchmarking of Hedge Funds: Can passive investments in hedge fund strategies
deliver?”, Journal of Alternative Investment (Winter 2005).
11
Source: Van Hedge Fund Advisors

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funding. Prime brokers have policies as to how much a certain type of
strategy can borrow and the margins provided for each strategy. These
policies can be subject to sudden change. It is important to understand
the implications of leverage (rather than stick to rigid policies such as
investing in strategies with no or little leverage only), because of its
impact on other sources of risk such as market, credit and liquidity risk.

V. Considerations for hedge fund risk management

The tasks of a hedge fund portfolio manager

A portfolio management process, if properly structured and set up, can

add significant value to hedge fund investors provided that the portfolio
manager (in most cases a fund of funds manager) adheres to some
fundamental criteria in his investment approach regarding strategy
allocation, manager due diligence, and risk management capabilities. The
following describes the three key duties of the hedge fund portfolio
manager:

1. Sector allocation (top down analysis): Deciding on the relative

allocation of capital to various hedge fund styles.

2. Manager evaluation (bottom up analysis): Evaluating the individual

managers’ strategies in a chosen style sector and a thorough
manager due diligence process.
3. Continuous monitoring/risk assessment: Monitoring open
investments for inappropriate risk and style drift.

Top-down strategy sector analysis and bottom-up manager evaluation,

though principally pre-investment activities (thus we refer to them also as
“pre-investment risk management”), must be periodically re-assessed
after the investment initiation (“post-investment risk management”).
However, post investment risk management faces some limitations if not
combined with regular position monitoring and the possibility of active risk
management. At the same time we emphasize that no amount of post
investment transparency and risk management tools can compensate for
a lack of knowledge about and confidence in the manager’s strategy and
his trading edge.

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Pre- investment risk management

Sector allocation
Top down strategy sector allocation consists of two core processes:

1. Strategic asset allocation (long term, i.e. six to 18 months): Selects

the accepted systematic risk factors and reach effective
diversification among them. The goal is here to appropriately
allocate capital among the various hedge fund styles and reach a
stable diversification across different return drivers, economic
functions and risk factors in the hedge fund universe. A popular
financial term for this process is “risk budgeting”.12
2. Tactical asset allocation (short term, i.e. one to six months):
Accounts flexibly for the changing dynamics of global capital
markets and return opportunities as well as the time varying
character of risk premia returns and ensures the regular re-
balancing of the desired risk budget structure within the portfolio on
a shorter time horizon. A statically fixed asset allocation can result
in widely fluctuating portfolio risk. Risk budgets need to be
reassessed and rebalanced frequently according to strategy sector
performances, market conditions, level of relative attractiveness
(and thus performance expectations) for the underlying set of
strategies.

Sector allocation has qualitative and quantitative components. It is less a

quantitative science than an art based on the investor’s experience. A
pure quantitative approach ignores the well known pitfalls of portfolio
optimization for hedge funds, while a pure qualitative approach ignores
the value of information about strategy features that can be obtained
through a statistical analysis of risk, return and correlation features of the
various hedge fund strategies. Empirical performance and correlation
studies can serve as a valuable guideline for the hedge fund
investor/allocator. However, no amount of statistical and econometric
analysis can replace proper judgment. A significant part of the qualitative
understanding is the assessment of the sources of return (especially for
the tactical asset allocation, since it is impossible to effectively predict the
time variation of manager skill).

12
For a coverage of the different aspects of risk budgeting, see the collection of articles edited by. L.
Rahl, “Risk Budgeting: A New Approach to Investing”, RISK Books 2000.

12
The four elements of the strategic sector allocation process are:

1. Judgment of the return drivers and opportunities of the various

hedge fund strategies. Return profiles across the universe of
strategies are very opaque and thus influenced differently by
developments in global capital markets.

2. Assessment of the desired risk types and magnitude for the

portfolio. Hedge fund strategies are rewarded for their exposure to a
variety of systematic risks (see below).

3. Determination of the correlation and dependence structure in

various market environments across the universe of hedge fund
strategies.

4. Identification of secular trends in the global capital markets: The

global financial, economic, and political trends determine the
performance of the various risk premia.

Components of tactical asset allocation are:

1. Consideration of mean reversion in risk factors: Many risk factors

show signs of mean reversion in their behavior (e.g. credit spreads,
volatility). In periods of extreme deviation of a risk factor’s behavior
from the longer-term value of its mean, an over-allocation to
strategies, which benefit from a reversion of this risk factor (by
relative outperformance) is particularly attractive.
2. Rebalancing exposure due to P&L: The relative performance across
the various strategies in the portfolio necessitates a frequent
rebalancing (e.g. CTA run-ups in relatively short periods of time).
3. Risk budget rebalancing: Due to the dynamically changing nature of
return opportunities and risk exposure in the different strategy
sectors, certain hedge funds can at particular times take more (or
less) risk - relative to their own expected average as well as relative
to other strategies. This often leads to a mis-balance of the risk and
correlation profile in the overall portfolio despite compliance with the
desired nominal allocation sizes according to the strategic sector
allocation. It is the balance of the risk exposure and risk type (i.e.
the risk budget), not the nominal allocation to the different
strategies, which one needs to consider in a proper risk budgeting
approach.

13
 4. Macro-economic outlook on risk factors: The attractiveness of return
drivers changes over time, even on a shorter time horizon, e.g. due
to changing economic circumstances (business cycle), political
events (e.g. elections, regulatory changes), geopolitical events (e.g.
war), or others.

Manager evaluation
Manager due diligence encompasses important elements of risk
management, and the decision to allocate money to a particular manager
is of ultimate importance for the investor. Each investment involves
certain manager risks, which are specific to trading styles and employed
investment techniques such as leverage, investment instruments, and
short selling. Manager specific risks also include operational risks, legal
risk, business risk (such as key person risk), model risk, and fraud risk.
Two pre- investment measures are essential in minimizing these risks:
proper due diligence and manager diversification. Thorough due diligence
should, without exception, be a requirement for an investment with a
particular hedge fund manager, and should result in a detailed
understanding of each manager’s individual trading strategy. Managers
within the same strategy sector can differ with regards to strategy
implementation, instrument diversification, hedging, use of derivatives,
short selling, and the degree of leverage13.

Unfortunately, many investors still rely too much on past performance

when selecting managers, without thorough qualitative analysis.
Qualitative aspects of the due diligence involve knowing the manager’s
“edge for returns”, the investment style and attitude of the manager,
details of the investment decision-making processes, the organization and
structure of the manager’s operations, the trading facilities, and the
character, quality and background of key people14. The first question to a
hedge fund manager should be “Why do you make money?” The second
question should be “How do you make money?” This answers most of the
most important question: “Will he continue to make money?”

13
Note that leverage itself is not a risk measure, but a way to increase and scale the risk and return
distribution of a strategy. It can serve (in combination with others) as one indicator for a strategy’s risk
level.
14
The “8 Ps” of manager due diligence are discussed in more detail in the book: L. Jaeger “Risk
management of Alternative Investment Strategies”, published by Financial Times/Prentice Hall in May
2002.

14
Prerequisites of post-investment management

The issue of transparency

“Transparency” has become a catchy expression and refers to a variety of
different possible information types disclosed to the investor. First, to
control the risk of his trading strategy as well as the specific risks of his
firm15 requires insight into the details of the manager’s investment
techniques and the operations of his company. It is undisputed that one of
the core responsibilities of the professional hedge fund investor and
portfolio manager (fund of funds) is to access this level of pre-investment
transparency and use this information for an optimal investment
allocation. Post investment transparency may then come in a number of
different (non-exclusive) forms, from regular qualitative information in
retrospective about the trading activity and direct conversations with the
manager (the weakest form) to obtaining a daily disclosure of all positions
from the manager’s prime broker (the strongest form).

Detailed insight into the activities of the hedge fund manager lies at the
very heart of the risk manager’s capability to perform his post-investment
monitoring task. It should be clear that without this knowledge, risk
analysis remains largely a guessing game. There is a wide spread
discussion within the hedge fund industry what constitutes the necessary
and appropriate information base the risk manager needs for monitoring
and managing risk effectively (in other words, what the right level of
hedge fund disclosure is) while at the same time protecting the interests
of the hedge fund manager. An important element of this discussion is
whether (standardized) information about the aggregated risk exposure
without complete position transparency is sufficient for monitoring and
risk management purposes, or whether regular full disclosure of all
positions is needed. While the Investor Risk Committee (IRC) advocates
the first solution16, the author of this chapter believes that – if possible -
the disclosure of trading positions is the most efficient way to ensure the
risk manager has all necessary information to independently assess and
control the risk in a particular hedge fund. Investors and hedge fund
portfolio manager (fund of funds) may not always need position
transparency on a daily basis for each strategy to effectively manage and
measure risk. But it should be clear that without sufficient transparency,
hedge fund investing and multi-manager portfolio diversification remains a

15
An important and much overlooked point perhaps is that it is not enough to be a skilled money
manager. Running a hedge fund also means running a firm, which requires a great deal of
entrepreneurial skills.
16
The investor risk committee is a group of hedge funds, service providers and investors with the aim
of developing risk disclosure guidelines for the hedge fund industry. See their publications: “Hedge
Fund Disclosure for Institutional Investors”, available on the IAFE Web-page: http://www.iafe.org or
on http://www.cmra.com, and the amendment in July 2001.

15
search in the darkness with the tendency to allocate most money to the
“stars of the past”.

Here, the distinction between “strategy” (or “style”) on the one hand and
manager specific (“idiosyncratic”) risk is important: While the exposure to
systematic risk can be partially assessed without the risk manager’s
insights into the details of the daily portfolio, for example through risk
based factor models on the return time series of the fund, the
idiosyncratic manager specific risks can by no means be sufficiently
analyzed and monitored. While the former needs to be dealt with on a
strategic asset allocation level and monitored with longer time horizons in
mind, the latter must not be left unattended at any moment or time
horizon. The real risk to the investor investing in hedge fund come from
comes from: a) unwanted and unknown leveraged systematic risk; b)
uncontrolled manager related risk (style drifts, faulty operations, fraud,
etc.). The control of both requires position information to the risk
manager.

However, the issue of transparency covers more than position disclosure,

and even complete transparency does not guarantee for proper risk
management. The “art of transparency”, i.e. the integration of
transparency into the risk management infrastructure, consists of a multi-
level process ranging from collecting the structural information about the
hedge fund in the due diligence prior to investment to efficiently dealing
with the possibly thousands of single position in hedge funds, the
appropriate valuation of all instruments in the portfolio, the calculation of
the appropriate risk variables and the definition of necessary risk
management activities. Position level risk analysis requires skills and
methodologies of their own which need to be developed by independent
third parties and risk monitoring agents17.

An interesting analogy regarding transparency and independent risk

monitoring for hedge fund strategies might be the following: Consider the
level of scrutiny for the investment activities inside financial institutions
like banks, broker dealers, corporate finance departments of large firms,
insurance companies, etc. The supervision of proprietary trading desks in
investment banks (where mostly the balance sheet capital of the bank is
traded) takes place in a very rigorous and independent risk-monitoring
framework. Consider further that many hedge fund strategies are quite
similar to proprietary trading at these desks (many hedge fund strategies

17
A further challenge lies in enabling the end investor (e.g. institutional investors) appropriately
interpreting the risk numbers. However, the emphasis of the argument here lies in the statement that
there needs to be independent party with the necessary skills and sophistication to perform the risk
monitoring.

16
actually came out of these institutions and are now seen as the
outsourced activities of the proprietary traders). It seems difficult to
imagine that external managers would be allowed to pursue these
investment activities in a completely unmonitored and largely unregulated
way. To make matters worse, these strategies are exposed to a much
larger variety of risk factors and can be made riskier at the discretion of
the manager.

Another interesting perspective on the question how much disclosure is

necessary can be obtained if one considers the position of prime brokers,
the other party next to the investor, which is exposed to the risk of
financial losses as a consequence of a Hedge fund manager’s trading
activities, as a lender of securities and provider of leverage. If risk and
exposure monitoring without disclosure of positions were sufficient for
appropriate risk management, the prime brokers would monitor their
exposures to Hedge funds based on “aggregated risk information” without
worrying about the tedious job of identifying single positions. However, in
reality, prime brokers have full transparency of positions on a continuous
basis. They consider position disclosure as the very foundation for their
own risk management.

The necessity for position disclosure and usefulness of full transparency

varies among the different hedge fund strategies. Model based systematic
strategies are easier to monitor and understand on a regular basis than
discretionary (i.e. not model based) strategies such as Long/Short Equity,
Macro, and Short Selling, where it is more difficult to follow the rationale
of positions on a standalone basis, i.e. without further information
provided by the manager. However, this is no argument against position
disclosure even for the latter strategies, as monitoring and controlling
exposure to the main risk factors as well as leverage and potential style
drifts are essential in all cases. The optimal frequency of disclosure is
related to the liquidity of traded instruments. For Distressed Securities
and Regulation D strategies weekly or monthly disclosures can be
sufficient, while for most other strategies, more frequent (i.e. up to daily)
position transparency is most useful and appropriate.

While standardized measures like gross and net exposure, leverage

factors, VaR numbers, simulated losses after predefined stress test
scenarios, etc. provide valuable insights into the hedge fund’s activity and
often constitute some basis for style drift monitoring, knowledge of
trading position enables the risk manager to assess the full magnitude and
all details of risk completely (and independently), especially in light of the
dynamic and complex nature of most hedge fund strategies.

17
Transparency based on position disclosure

• allows to measure and analyze the risk profile of a particular Hedge

fund strategy which is the very basis of active risk management
• provides the possibility of detecting previously unknown (or
unrecognized) risks in the investment strategy. Whilst one might
obtain good insights from past performance behavior, certain risk
factors may yet have to be experienced (e.g. LTCM)
• enables the Hedge fund investor to recognize undesired style drifts
and singular “bets” early enough.
• allows leverage to be controlled.
• enables the investor to examine all agreements the hedge fund is a
party to such as prime brokerage agreement, fee agreements, past
audit reports, corporate registration and others.
• significantly decreases the probability of fraud18.
• provides support for the challenging task of performance
measurement.

The Issue of Liquidity

The benefits of transparency in a hedge fund portfolio cannot be fully
realized if the investor is not provided with sufficiently short redemption
periods. It is obvious that if the investor faces redemption periods that do
not correspond to the frequency of provided transparency, he is prevented
from responding to time sensitive information and taking the necessary
steps according to his analysis. The hedge fund investor has to be
proactive and should be in a position to take steps to remedy critical
situations in a timely fashion. Often, when a crisis has arrived, it is too
late to make adjustments.

Hedge fund “liquidity” has two different meanings: 1) the ability to sell an
investment without a price impact (instrument liquidity) and 2) the
availability of financing for leverage (funding liquidity). The hedge fund
investor should understand the liquidity of the instruments in which a
strategy invests and the sources and reliability of leverage financing. The
best liquidity indicator for a strategy is the market liquidity of the traded
instruments. Managed Futures, large cap Long/Short Equity, Macro,
Market Timing and Risk Arbitrage strategies involve highly liquid exchange
traded instruments, as do most arbitrage and Relative Value strategies
(with some exceptions for Convertible and Fixed Income Arbitrage

18
The other side of the coin of the hedge fund boom is a boom in hedge fund fraud. A good article
about Hedge fund fraud cases is presented by D. Kramer in the article “Hedge Fund Disasters:
Avoiding the Next Catastrophe” in the Alternative Investment Quarterly, (October 2001); See also an
interesting article by T. Fedorek, “Is Fraud Flourishing At Your Hedge Fund?” Pension & Investment,
March 19th 2001, p.14.

18
strategies19). On the other side of the spectrum are Distressed Debt and
Regulation D strategies, which are generally extremely illiquid. However, it
is important to note that the liquidity of investments can be very different
in times of turbulence in capital markets. Liquidity tends to evaporate,
when it is most needed. An extreme example of previously unknown
liquidity risk was the “flight to quality” event in September 1998, which
led to the failure of LTCM20.

It is important to note that most hedge funds operate in markets that

exhibit a high degree of efficiency and liquidity. In most cases hedge
funds only trade the most liquid stocks and bonds, the most liquid
currencies, and futures markets. This liquidity stands in great contrast to
the rather extended redemption periods of many hedge funds (ranging
from one month to several years). Note further that most redemption
policies can be overridden in extreme market environments, as many
managers include clauses in their offering memorandums giving them the
right to suspend redemptions during certain vaguely defined scenarios of
market turmoil, regardless of normal liquidity policies. Until recently
hedge fund managers have not been asked for shorter redemption periods
nor have they been willing or operationally capable of providing it (one
reason why hedge fund managers are not willing to provide this liquidity is
the involved administrative back office process for frequent redemptions
and subscriptions as most hedge funds have very limited resources to do
so). But if the hedge fund manager executes strategies with comparably
high liquidity in the underlying instruments, why should the investor be
confronted with long redemption periods?21

Many strategies employ leverage and thus rely on external funding.

Funding liquidity risk is largely determined by the prime brokers’ “haircut”
policies, which specify the leverage and margin requirements for the
manager’s strategy. The Hedge fund investor should consider the “haircut
sensitivity”, i.e. the sensitivity to changes in the haircut policy of the
broker, when examining a strategy’s liquidity risk. Managers can become
victims of leverage in situations of financial turmoil, when prime brokers
refuse to continue to provide financing leverage because of increased risk
19
Convertible bonds are usually traded OTC as are swaps and other fixed income and credit
derivatives. However, with the proliferation of these instruments liquidity has often reached high
levels.
20
For a well written and quite entertaining account of LTCM we recommend ‘When Genius Failed: The
Rise and Fall of Long-Term Capital Management’ by Roger Lowenstein (Random House, 2000); se also
report of the President's Working Group on Financial Markets, “Hedge Funds, Leverage, and the
Lessons of Long-Term Capital Management,” April 1999, available on http://risk.ifci.ch/146530.htm.
21
The rise in popularity of managed accounts (see discussion below) by fund of funds is about to
change this. Managed accounts offer hedge fund liquidity to the level the liquidity of the instruments
traded, so it will be in the hand of the fund of funds that employ managed accounts to structure
products with the necessary liquidity.

19
of positions held. This can lead to forced liquidation of the positions at an
inopportune time thus creating large investment losses. The manager’s
relationship with his prime broker is therefore an important element in the
implementation of his trading strategy.

Dealing with Operational Risks

Hedge funds are inherently more complex than traditional investments

trading a wide spectrum of different asset classes and instruments and
include features like leverage, short selling, complex derivatives trading,
spread positions, and illiquid investments. Besides the exposure to an
often very complex interaction between a whole spectrum of different
investment risks that, hedge fund risk managers have more recently
focussed on the issue of operational risk, often broadly defined as the
risk of failure of internal systems, technology, people, external systems,
or physical events. Because Hedge funds and Managed Futures have a
much higher transaction turnover and usually less back-up staff compared
to traditional asset managers, operational risks can be significantly
higher22. Thus their operational risk comes in an even wider spectrum of
formats than other risk factors. A general rule applies: The more complex
a strategy and the lower the dedicated resources to deal with them, the
higher the operational risk. A specific occurrence of operation risk is in the
form of model risk, present especially in those strategies that rely on
complex pricing and valuation models such as many arbitrage strategies
(convertible arbitrage, fixed income arbitrage, capital structure arbitrage).
In their 2003 study (see footnote below), Capco come to the conclusion
that more than half of hedge fund failures are related to operational risk
of some sort with the most common issues being related to
misrepresentations of fund investments, misappropriation of funds,
unauthorized trading, and inadequate resources. Often a combination of
those factors is in place.
Operational risk must be assessed in detail on the level of the manager
due diligence as problems that lie at the bottom of operational risk often
show up beforehand if considered carefully23. Capco has defined 5 key
characteristics of an effective operational due diligence approach for
hedge funds:

22
See the study by Capco, “Understanding and Mitigating Operational Risk”, Capco 2003, for further
details on how much hedge funds are exposed to operational risks.
23
See L. Jaeger, “Risk Management in Alternative Investment Strategies”, Financial Times Prentice
Hall (2002) for more details.

20
 • Providing a comprehensive view of the structure, quality and control
of the people, operations, technology and data supporting the fund
• Checking internal processes, systems and information flows
• Examining the processes, systems, information flows and interfaces
provided by external parties such as prime brokers, administrators,
custodians, etc.
• Analyzing the unique requirements of each fund/strategy as they
can vary considerably depending upon fund objectives and
investment style
• Periodic updates of the assessment, especially after any sort of
“event”

We add that post-investment risk management and transparency with

respect to the manager’s activities equally lie at the heart of managing
operation risks.

VI. Elements of post-investment risk management: The

monitoring and risk analysis process

“Post investment risk management” essentially consists of two elements:

the periodic re-evaluation of the manager (performance, skill base,
uniqueness, operations, people, etc.) and frequent risk analysis. When it
comes to quantitative risk analysis a variety of different tools are today
available to the investors. Furthermore, risk service providers have
developed business models to provide investors a range of calculation and
analysis tools. The offered tools are increasingly geared towards hedge
funds. The following aims at providing an overview on applicable risk
analysis and monitoring tool as well as some results on applying some less
well known quantitative risk analysis techniques. The calculations shown
in the following are taken from a joint publication of the author with P.
Blum and M. Dacorogna.24

Exposure analysis

Risk is a combination of exposure and uncertainty. Besides aggregate

exposure on the level of the global portfolio, exposure analysis is
breakdown of the exposure to different aggregation levels. It further
includes monitoring of certain exposure rations such as margin
characteristics and leverage factors (net and gross leverage), credit
quality, hedge ratios, etc.

24
P. Blum, M. Dacorogna, L. Jaeger, “Performance and risk measurement challenges for hedge funds:
empirical considerations”, in L. Jaeger (ed.), “The New Generation of Risk Management in Hedge
Funds and Private Equity Investments”, Euromoney 2003.

21
Value at Risk (VaR) and Expected Shortfall

VaR has introduced a new dimension of risk analysis to the financial

community and is today the most widely used quantitative analysis tool in
the financial risk management community. The magic of VaR is that it
introduces a uniform measuring system for various risks in a global
portfolio by providing a method for comparing risk across different
instruments and asset classes. The two important parameters that a risk
manager has to define for VaR are the time period and the confidence
level (e.g. 99% for a one-day horizon). But VaR provides only a very
incomplete picture of the extreme left tail region of the distribution. VaR
does thus not help us to forecast and prevent unacceptable losses. It is
undisputed among theoreticians and practitioners of risk management
that VaR needs to be supplemented by other analytical tools to cope with
extreme market conditions (e.g. stress tests).

Standard VaR(99% ES(98.75% VaR(99.6% ES(99%)

Deviation ) ) )
MSCI World Sovereign 0.37% -0.90% -1.08% -1.10% -1.27%
Index
Foreign Exchange 0.52% -1.37% -1.66% -1.78% -1.75%
(USD/GBP)
Daily Hedge Fund Index 0.77% -1.95% -2.32% -2.41% -2.44%
Dow Jones Industrial 1.08% -2.92% -3.77% -3.76% -4.04%
Brazilian Stock Index 2.96% -7.85% -9.59% -10.13% -10.20%

Table 1: Empirical estimation of various risk measures for a set of

financial instruments. The estimation is based on the logarithmic returns
of 10 years of daily prices25 (1.1.1993 – 31.12.2002) (sample
information). The data is ordered by increasing volatility (standard
deviation).

One of the drawbacks of VaR is that it measures only one specified point
on the distribution function, thereby neglecting valuable information about
the rest of the distribution. In particular, one is interested in what
happens in the 1% or 0.4% of cases when the loss exceeds the VaR
value; in other words one wants to know: “How bad is bad?” A risk
measure which addresses this issue is Expected Shortfall (ES, also known
as Conditional VaR or Tail VaR). ES quantifies the risk of extreme loss in
those events which exceed the threshold given by VaR. It is simply the
average outcome of X given that X is beyond VaR:

25
The hedge fund index is a collection of managed futures and long/short equity funds that provide
daily NAV's; it was made available by Partners Group. Data for the other instruments comes from
Bloomberg Data License

22
ES( ) = E[X|X≥VaR( ],

(the symbol E denotes the mathematical expectation operator). ES is

numerically more stable than VaR because it is the result of an averaging
procedure, and does not rely only on one point on the probability
distribution.

Another drawback of VaR is that it can have bad aggregation properties

with respect to sub-portfolios. In certain situations the VaR of a portfolio
consisting of two sub-portfolios can be larger than the sum of the single
VaR values of the two sub-portfolios. This would neglect the benefits of
diversification. In other words, VaR itself does not qualify as a “coherent
risk measure” 26(see Artzner et al. 1999).

The goal is to have a risk measure that has the following desirable
properties (coherence):

1. Scalability (twice the risk should give a double measure),

2. Correct ranking of risks (bigger risks get bigger measures),
3. Accounting for diversification (aggregated risks should have a
lower measure).

It can be shown that, on top of the other desirable properties described,

Expected Shortfall also qualifies as a coherent measure of risk.

In Table 1 we show values for the various described risk measures

estimated empirically on the logarithmic returns of 10 years of daily prices
of various asset classes. One can observe that the expected shortfall gives
a more conservative estimate of the risk than the VaR. The threshold at
which the risk is measured is important. If one chooses to be less
conservative but retain the advantages of a coherent measure, the
Expected Shortfall can be used with a lower threshold, say 98.75%.

Evaluation of risk measures

While VaR and even expected shortfall are conceptually and intuitively
quite simple, the technical details of their calculation can be rather
involved, depending on the heterogeneity of the portfolio and the
distributional assumptions made. Here follows a short overview that
applies to all risk measures.

26
See Artzner P., Delbaen F., Eber J. and Heath D., “Coherent Risk Measures”“, Mathematical Finance,
vol. 9 (3), pages 203-228 (1999).

23
The three main elements of standard risk measure calculation are:

• Mapping the portfolio positions to risk factors.

• Calculating the risk factor covariance matrix based on historical
prices.
• Determining the model for the risk and calculating the risk measure.

Mapping risk factors

Risk factor mapping is equivalent to decomposing individual securities in a
portfolio, and categorizing the risks they present into those over which the
risk manager has control (exposure) and components that are exogenous
(risk factors). Prices of the thousands of financial securities available
worldwide are influenced by common risk factors. A risk factor is a
variable that directly affects the value of a security. Individual securities
are usually influenced by a variety of different risk factors. Examples of
risk factors are interest rates, the broad equity market as represented by
stock indices, FX rates, and credit spread curves.

The dependency of a security on a specific risk factor (the security’s

“sensitivity”) is expressed in a “pricing function” and can take a variety of
different forms (linear as well as non-linear). The pricing function usually
depends on the particular VaR method used (see below). The concept of
risk factors and sensitivities is not a new one. Sensitivities to certain
factors have been used for many years for the management of yield curve
risks, as well as in option theory. Examples are the “value of a basis point
move” or the “Greeks”. A simple (here linear) model of this type, which is
often referred to as "Factor Pricing Model", could be formalized as:
N
Rt = α + ∑ β n ⋅ Fn ,t + ε t
n =1

Here, Rt is the return of the financial asset, is a deterministic

component (i.e. the risk-free rate of return), Fn,t are random variables
representing the outcomes of observable risk factors that affect the
market as a whole (e.g. equity market portfolio returns, interest rates,
inflation), n is the sensitivity of Rt to Fn,t, and t is the idiosyncratic risk
of Rt, i.e. the specific risk not attributable to one of the risk factors. There
are various degrees of freedom in the structure of such a pricing model:
the number of risk factors can vary, and the dependence on the risk
factors can be linear (as in the example) or non-linear (which appears
particularly sensible in the realm of hedge funds). The pricing functions
have to be correctly adjusted by calibrating the model parameters to the
market prices of specific benchmark instruments.

24
Moreover, different kinds of constraints may apply to the parameters. If
these constraints are aimed at eliminating arbitrage, then we are in the
realm of the well-known Arbitrage Pricing Theory. Once such risk factor
mapping is in place, there still remains the task of defining a suitable
stochastic model for the risk factors to be able to estimate risk measures
for the various assets Rt and the portfolio in total. This topic is covered in
the following sections.

Calculation of Covariance Matrix

The next step in calculating the portfolio risk consists of estimating the
dependence between the risk factors. If one makes the standard
assumption that security returns are multivariate normally distributed, the
correlation matrix (together with the vector of expected returns) uniquely
determines the distribution of portfolio returns, and therefore any risk
measure for the portfolio. We briefly present the usual methods of
estimating the covariance matrix, but we shall see in the next section that
the assumptions made thereby are very restrictive and should not be
applied without careful examination of their validity, especially in the
cases of extreme outcomes. There are various methods for calculating
volatility (variances) and correlations (co-variances). The following
variance and co-variance models are most commonly used (the
RiskMetrics Technical document (1996) is still an excellent source for
details27).

• Equally weighted moving average of squared returns and cross

products over some specified time horizon.
• Exponential moving average of squared returns and cross products with
specified decay parameter. This is the method chosen by RiskMetrics
and many others. The decay parameter chosen is 0.94 for daily
observations and 0.97 for monthly observations.
• The family of ARCH models: ARCH (autoregressive conditional
heteroskedastic) and GARCH (General ARCH) models that were
developed in the early 1980s have become a starting point for
sophisticated volatility and correlation forecasting models28. The
exponential moving average model can be seen as a special case of a
GARCH model.

The main problem in estimating the covariance matrix is that the number
of risk factors can be quite large. The higher the dimension of the matrix
the more observations are needed to estimate the matrix to a sufficient
27
For more information and a discussion of the quality of different volatility and correlation forecasts,
the reader is referred to Carol Alexander’s book: Market Models; A Guide to Financial Data Analysis
(2001).
28
See the article by Tim Bollerslev et al.: “Arch modeling in finance,” Journal of Econometrics, 52, p.5-
59 (1992).

25
degree of accuracy. Practitioners often do not consider this point enough,
which can affect considerably the stability of the results. Another
limitation of the covariance matrix is the fact that the dependence
between risk factors is usually neither linear nor static. It is a known fact
among practitioners that the dependence may increase during crises29.

Calculation of Risk Measures

After attributing cash flows to risk factors and calculating the risk factors’
co-variance matrix, risk measures can be calculated using several
methods that differ mainly in respect to two factors:

1. Assumptions regarding security valuation as a function of risk

factors. A determination must be made as to the sensitivity of
security prices to changes in risk factors. The industry distinguishes
between local valuation and full valuation methods.

2. The distributional assumptions made. The industry distinguishes

between parametric (mostly Gaussian) distributions versus historical
distributions. In Table 2, we estimated the risk measures from the
historical distributions. We note that, with the use of a co-variance
matrix, one implicitly makes the assumption that the multi-variate
distribution of the risk factor set is elliptical

The three most popular methods to compute risk measures (including VaR
or Expected Shortfall) are:

1. Parametric approach. The idea behind parametric models is to

approximate the pricing function of every instrument, i.e. the
relationship between each instrument and the risk factors, in a way
that an analytical formula for the risk measures can be obtained.
The simplest parametric approach is the delta method, also referred
to as “variance-covariance based VaR”30.

29
See the following study: Hauksson H. A., Dacorogna M. M., Domenig T., Müller U. A. and
Samorodnitsky G., “Multivariate Extremes, Aggregation and Risk Estimation”, Quantitative Finance,
vol. 1(1), pages 79-95 (2001).
30
This method is often called the “RiskMetrics VaR” method, as this was the original method
introduced by RiskMetrics in the early 1990s. However, today RiskMetrics also offers other parametric
VaR approaches as well as Monte Carlo based and historical simulation VaR.

26
 2. Monte Carlo simulations31. The Monte Carlo method is a full valuation
method based on simulating the behaviour of the underlying risk
factors through a large number of draws produced by a random
generator. Using given pricing functions, the values of the portfolio
positions are calculated from the simulated values of each risk factor.
The method accounts fully for any non-linearity of the relationship
between instrument and risk factors, as the positions in the portfolio
are fully re-valued under each of the random scenarios. Every random
draw of risk factor values leads to a new portfolio valuation. A high
number of iterations (several thousand) provide a simulated return
distribution of the portfolio, from which the VaR or the Expected
Shortfall values can be determined (a number of numerical techniques
exist for making simulation more efficient and more accurate). The
underlying distribution of the randomly generated values of the risk
factors can essentially be chosen freely, and – in particular – one is not
constrained to the Gaussian distribution since analytical tractability
does not matter in the Monte Carlo set up. However, the use of non-
Gaussian distributions can involve some mathematical problems32 in
terms of simulating the dependency structures of the risk factors
correctly, as outlined in Section 4 below.

3. Historical simulation. Instead of simulating return distributions, they

can be determined by looking into the past. The historical method is
also a full valuation method and relies on the (unconditional)
historical distribution of returns by applying past asset returns to the
present holdings in the portfolio. The values of the portfolio
positions are then fully evaluated for each set of historical returns.
This method has the advantage that no explicit assumptions about
the underlying return distribution have to be made. However, the
problem with this method is that it relies on historical price
behavior, which may not be relevant in the current conditions, or
may form a too small sample to assess all the possible outcomes,
particularly in the tails of the distribution. Moreover, this method is
not sensible (and workarounds are difficult) if significant inter-
temporal dependence is present in the returns.

31
In “Beyond Value of Risk”, Wiley Frontiers in Finance, John Wiley & Sons Ltd, New York (1998).
(chapter 5) Kevin Dowd presents a good discussion about the different aspects of Monte Carlo
approaches.
32
See the excellent paper by P. Embrechts, Mc Neil A. and Straumann D., “Correlation and
Dependence in Risk Management; Properties and Pitfalls”, in Risk Management: Value at Risk and
Beyond, edited by Dempster M., Cambridge University Press, pages 176-223 (2002).

27
Even in the case of the Monte Carlo simulation, it is still commonplace
among practitioners to assume that risk factor returns follow a normal
("Gaussian") distribution with the mean and standard deviation observed
in the historical data33. While this is convenient from a computational
point of view, it bears the danger of underestimating extreme risks and
related tail-based risk measures as Value-at-Risk. As long as normally
distributed draws are used (as is often the case in practice), even the
Monte Carlo method does not address the issue of non-normally
distributed asset returns. However, the use of Monte Carlo simulations is a
starting point to the modeling of fat-tails and non-linear dependencies,
and is thus gaining favor among practitioners willing to go beyond the
Gaussian model34. The dependence and correlation structure of non-
normal multivariate distributions is still the subject of intense
mathematical research.

In Table 2 we compare the VaR estimates obtained from the full

distribution of historical returns ("Empirical") with VaR estimates for the
same risk levels obtained by making the assumption of normality
("Gaussian"). We can clearly see that the Gaussian model systematically
underestimates the actual risk. Even worse, the degree of underestimation
becomes higher the further out we stretch in to the tails. The section
below will treat the problem of properly modeling extreme events in more
detail.

VaR 99% VaR 99% VaR VaR

(Gaussian) (Empirical) 99.6% 99.6%
(Gaussian) (Empirical)
MSCI World Sovereign -0.85% -0.90% -0.97% -1.10%
Index
Foreign Exchange -1.21% -1.37% -1.38% -1.78%
(USD/GBP)
Daily Hedge Fund -1.71% -1.95% -1.96% -2.41%
Index
Dow Jones Industrial -2.48% -2.92% -2.83% -3.76%
Brazilian Stock Index -6.59% -7.85% -7.56% -10.13%

Table 2: Value-at-Risk computed with the empirical distribution and under

the assumption of a Gaussian distribution (sample information).

33
Notice that the Gaussian distribution is fully determined by its mean and standard deviation.
34
The insurance industry, increasingly confronted with the problem of non-linear dependencies and
fat-tailed distributions, has developed a Monte Carlo method called Dynamic Financial Analysis (DFA)
in order to cope with this problem. For an introduction to this technique, see Blum and Dacorogna
2003.

28
Stress tests and scenario analysis

Stress tests apply extreme scenarios to the portfolio in order to ascertain

coverage of the impact of pre-determined extreme price changes in the
market. Such tests give insight to the portfolio behavior under extreme,
but plausible, market conditions. We distinguish two different types of
scenario underlying stress tests: historical scenarios (eg, the equity
market crash of October 1987), and general market scenarios (eg, a drop
of 15% in a certain currency), which includes appropriate size shocks,
asymmetries in return distribution, and correlations considerations (e.g.
shocking different combinations of asset classes separately and
combined).

Extreme value theory

One of the crucial points for a risk manager is to quantify risks in periods
of tension or crisis on the global capital markets. It is precisely during
these periods when risk management should prove its value. Financial risk
exhibit fat tails (leptokurticity), i.e., extreme events are more likely to
occur compared to what a normal distribution suggests. Most available
tools for parametric VaR estimation, such as GARCH models (general
autoregressive conditional heteroskedasticity models), are designed to
predict common volatilities, and therefore have poor tail properties.

Hedge funds have shown in the past that they can serve as valuable
portfolio diversifying investments in times of market crises, but equally
have exacerbated losses in certain instances (e.g. during the crisis of
summer 1998). There has been only little research performed so far to
help assess extreme risks for hedge funds differentiate themselves from
the crowd behavior of financial assets in distressed capital markets. There
are two elements that need to be examined: the extreme risks of single
hedge fund strategies (i.e. amount of probability that is in the tails of the
distribution) and a possible change in the dependence between hedge
fund risks and other investments during periods of market turmoil.

To assess purely the presence of fat tails, one can simply estimate the
kurtosis of the logarithmic returns of a time series empirically, using
returns measured at different time horizons, and compare the values
obtained for the performance of hedge funds with those from the
underlying markets traded. This way one can obtain a first indication of
whether hedge funds have been able to cope with extreme risks. The
kurtosis is related to the fourth moment of the distribution, and can be
estimated empirically from historical data. The convergence of the fourth

29
moment is not guaranteed for financial data35 but this does not prevent us
from computing this quantity in order to obtain an initial idea of how
heavy-tailed the distribution can be.

Financial Instruments Mean Standard Skewness Excess

Deviation Kurtosis
Tremont Hedge Fund Index 0.89% 2.56% 0.10 1.39
Tremont Convertible 0.82% 1.40% -1.62 4.12
Arbitrage
Tremont Dedicated Short 0.20% 5.31% 0.84 1.96
Bias
Tremont Emerging Markets 0.68% 5.26% -0.54 3.67
Tremont Equity Market 0.84% 0.89% 0.12 0.18
Neutral
Tremont Event Driven 0.85% 1.81% -3.32 21.18
Tremont Fixed Income 0.60% 1.35% -1.14 13.94
Arbitrage
Tremont Global Macro 1.17% 3.67% -0.02 1.59
Tremont Long/Short Equity 0.97% 3.32% 0.24 2.91
Tremont Managed Futures 0.57% 3.46% 0.04 0.84
MSCI World Equity Index 0.35% 4.29% -0.59 0.35
MSCI European Equity Index 0.37% 5.46% -1.24 4.25
S&P 500 0.70% 4.68% -0.58 0.17
Lehman US Bond Index 0.74% 2.43% -0.13 0.20
SSB Bond Index 0.50% 1.83% 0.44 0.47

Table 3: Basic descriptive statistics for some hedge fund indices

compared to classical financial markets (monthly logarithmic returns,
January 1994 – December 2002) (sample information).

The kurtosis measures the amount of probability mass that is

concentrated in the tails. Empirically the excess kurtosis (excess
compared to the normal distribution whose kurtosis is three) can be
estimated as follows:

⎧⎪ n(n + 1) n
⎛ xi − µ ⎞ ⎫⎪
4
3(n − 1) 2
Kurt = ⎨ ∑⎜ ⎟ ⎬ −
⎩⎪ (n − 1)(n − 2)(n − 3) i =1 ⎝ σ ⎠ ⎭⎪ (n − 2)(n − 3)

35
See Dacorogna M. M., Müller U. A., Pictet O. V. and De Vries C., “The Distribution of Extremal
Foreign Exchange Rate Returns in Extremely Large Data Sets”, Extremes, vol. 4(2), pages 105-127
(2001).

30
where is the mean and the standard deviation of the data. Positive
values of the excess kurtosis signal a heavy tailed distribution.

In Table 3 we report empirical estimates of the first four moments of the

return distribution of various hedge fund strategies and traditional
markets. We have added to the kurtosis the skewness that gives us the
degree of asymmetry of the distribution. The equity indices are known to
exhibit a negative skewness, which is clearly visible in the table for the
MSCI and S&P 500 indices. It is interesting to note that one can learn a lot
from such simple statistics. Some of the hedge fund indices in the table
present considerably higher kurtosis than stock or bond indices, while
their values for the standard deviations are lower than or equal to the
other indices. We note that the computation of basic moments provides an
idea of whether conventional portfolio optimization techniques can be
applied. These techniques require that the returns do not exhibit
significant skewness or excess kurtosis. These assumptions are obviously
violated, as shown in Table 3, e.g. for the Tremont Convertible Arbitrage
Index.

Convertible Arbitrage MSCI World Equity Index

Equity Market Neutral Equity Market Neutral

-0.05 0 0.05 -0.2 -0.1 0 0.1

Figure 1: Comparison of empirical probability densities of monthly returns

of two hedge fund indices (on the left) and of one hedge fund index and a
stock index (on the right) (sample information).

To illustrate further the message given by the values computed in Table 3

we draw in Figure 1 the full empirical probability densities of monthly
returns for two of the hedge fund indices, Convertible Arbitrage and Equity
Market Neutral, and compare them with the MSCI World Equity Index.
One can see clearly the asymmetry of the distribution and, on the left, the
fat left tail for the Convertible Arbitrage index. One can further see on the

31
right plot that the distribution for the MSCI is much wider than for the
Equity Market Neutral strategy.

Extreme value theory (EVT) provides the theoretical background for the
description of the asymptotic distribution of the tails of leptokurtic
distributions36. After determining the tail properties of the data, the VaR
can be estimated as a quantile of the determined extreme value
distribution. Studies have shown that VaR calculated on the basis of an
underlying EVT distribution is considerably higher than normal VaR37. In
other words, VaR calculated on the basis of standard volatilities and
correlations severely underestimates the real risk.

As long as we are only interested in the extreme events, we do not need

to consider models that cover the full range of possible outcomes, as the
Gaussian model does. Instead we can restrict our attention to dedicated
methods for the analysis of extreme events, i.e. the analysis of the tails of
the probability distribution, which can be described by a function F(x)
where x takes only values greater than some specified threshold u.
Powerful methods for this tail analysis come from the realm of EVT, which,
in recent years, has become fairly popular in various areas of quantitative
risk management

One of the fundamental theorems of EVT states that for a broad class of
probability distributions F(x) (including most of those popular in finance),
the tail behavior above a sufficiently high threshold u falls into one of
three classes:

1. Fréchet or heavy-tailed class: the tail of 1 – F(x) is essentially

proportional to a power function x- for some > 0. This means that
the tail decays slowly and the probability of extreme outcomes is
relatively high. The parameter that essentially governs the tail
behavior is called tail index. The closer is to 0, the higher is the
tendency for extreme outcomes.
2. Gumbel or thin-tailed class: the tail 1 – F(x) is essential proportional to
an exponential function. This means that the tail decays quickly and
the probability of extreme outcomes is relatively low, though not nil.

36
The well-known Fisher-Tippett theorem gives an explicit form of the asymptotic distribution of the
tails for a wide class of different distributions. A good reference for the mathematical properties and
theorems of extreme value can be found in P. Embrecht et al, Modelling Extremal Events, Springer
(1999). See also, A McNeil, Extreme Value for Risk Managers, in: Internal Modelling and CAD II,
published by Risk Books, 93-113 (1999).
37
S. N. Neftci, Value at Risk Calculations, Extreme Events, and Tail Estimation, The Journal of
Derivatives, Spring 2000, p. 23, and J. Danielsson, C. de Vries, Value at Risk and Extreme Returns,
Tinbergen Institute discussion paper, TI, 98-017/2, 1998 (21).

32
 The thin-tailed case corresponds to the limit of the heavy-tailed case
for the tail index tending to infinity.
3. Weibull or short-tailed class: the tail is zero above some finite
endpoint. If it comes to modeling the returns from financial assets,
truncated distributions are generally not considered, since one cannot
define a reasonable endpoint.

Notice that there is a linkage between the definition of "heavy tails" in

terms of the kurtosis and in terms of the tail index . Another important
theorem of EVT says that if a distribution has tail index , then the nth
moment of the distribution is infinite for n> . So, if a distribution has,
say, =3.5 (a value quite often seen in returns distributions of financial
assets), then its skewness (3rd moment) is finite, whereas its kurtosis (4th
moment) does not converge to a finite value. If, on the other hand, we
measure a very high excess kurtosis in a sample of returns, we can take
this as an indication that a heavy tail is present.

Instead of investigating the tail of F(x) itself, one can also investigate the
excess distribution of the return variable X above the threshold u. This is
the conditional distribution of X-u given that X is greater than u, i.e.

Fu ( y ) = Pr( X − u ≤ y | X > u )

The original distribution F(x) for x ≥ u can then be recovered via:

F ( x) = (1 − F (u )) Fu ( x − u ) + F (u )

Indeed, yet another main theorem of EVT states that, for some reasonably
high threshold, u, Fu(y) can be approximated to deliberate accuracy by the
Generalized Pareto Distribution (GPD), which is defined as:

⎧1 − (1 + ξ y / β ) −1/ ξ |ξ ≠ 0
Gξ , β ( y ) = ⎨
⎩ 1 − exp(− x / β ) |ξ = 0

While >0 is a mere scale parameter, governs the shape of the

distribution. It can be verified from the above definition that
corresponds to the heavy-tailed case, is the thin-tailed case, and
the short-tailed case. In the first case, the relation
holds for the shape parameter which explains the name tail index for .
For the reader interested in the finer mathematical details, we note that it
is easy to verify that the different values of (resp. ) give rise to the
different classes of tail shapes introduced above. Hence, tail analysis
essentially boils down to estimating the shape parameter .. Assuming

33
the GPD model, a variety of methods is available, including the well known
Maximum Likelihood technique. Methods exist for cases in which
observations show serial correlations, besides those methods applicable to
the basic case of uncorrelated observations38. As an alternative to this
parametric approach, non-parametric approaches to tail index estimation
are available. The most popular is known as the Hill estimator39. All these
approaches come with confidence intervals for the estimates obtained,
allowing the statistician to judge whether some estimated . is actually
significantly greater than zero, indicating a heavy tail.

Easy though it may look, practical tail estimation suffers from a number of
problems. The most basic one is the selection of a reasonable threshold u,
on which the estimated tail index is often heavily dependent. Moreover,
the amount of data available in the tail is often very low, leading to broad
confidence intervals and only weakly significant estimates. The latter
problem applies particularly to the realm of hedge funds, as described
above. Practical tail estimation is therefore rarely a straightforward
process in practice. It usually involves some trial and error and good
judgment. The good news, however, is that powerful tools and algorithms
are available today (see again the references stated above in footnote 34
and 35).

Once we feel sufficiently confident with the estimated tail model, we can
use it to estimate tail-related risk measures such as VaR and Expected
Shortfall. We demonstrate the case for the GPD model, and assume no
serial correlation in the data. Substituting the GPD for the excess
distribution Fu(y) in the above representation and recalling the definition
of Value-at-Risk, we obtain the following easy-to-compute formula:

−ξ
β ⎛⎛ n ⎞ ⎞
VaRq ( X ) = u + ⎜⎜ (1 − q ) ⎟ − 1⎟
ξ ⎜ ⎝ Nu ⎠ ⎟
⎝ ⎠

where n is the total number of observations and Nu is the number of

observations exceeding the threshold u and the other parameters are as
defined above. Recalling the definition of the Expected Shortfall, we
furthermore obtain:

38
For more details, see: Embrechts P., Klüpperberg C. and Mikosch T., Modelling Extremal Events for
Insurance and Finance, 2nd edition, Springer Verlag, Berlin (1999); McNeil A., "Extreme Value Theory
for Risk Managers", in Internal Modelling and CAD II , pages 93-113, RISK Books, 1999; See also
http://www.math.ethz.ch/~embrechts/ for additional materials.
39
For more details, see: Embrechts P., Klüpperberg C. and Mikosch T., Modelling Extremal Events for
Insurance and Finance, 2nd edition, Springer Verlag, Berlin (1999);
34
 VaRq ( X ) β −ξu
ES q ( X ) = +
1−ξ 1−ξ

The benefits of estimating tail-related risk measures by using a model

instead of just historical data are twofold. First, we can estimate at
quantiles q beyond what is covered by available data. Moreover, even if
we are within quantile ranges still covered by historical data, applying the
model yields smoother estimates, which is a considerable advantage given
that we usually only have low amounts of data out in the tail.

Excess Shape 90% conf. VaR VaR 95% VaR

Kurtosi pa- interval for 95% GPD 99.6%
s rameter empiric model GPD
al model
Hedge Fund Index 1.39 -0.2968 [-0.47,- 6.05% 5.88% 8.44%
0.15]
Convertible Arbitrage 4.12 0.0828 [- 3.24% 2.99% 5.30%
0.17,0.35]
Dedicated Short Bias 1.96 0.2814 [- 8.80% 9.37% 18.63%
0.08,0.69]
Emerging Markets 3.67 0.2181 [- 9.80% 10.24% 22.14%
0.26,0.70]
Equity Market Neutral 0.18 -0.2606 [-0.43,- 2.14% 2.38% 3.28%
0.07]
Event Driven 21.18 0.3105 [- 3.09% 3.37% 7.15%
0.10,0.72]
Fixed Income Arbitrage 13.94 0.3759 [0.06,0.69] 2.01% 2.41% 6.32%
Global Macro 1.59 0.1110 [- 9.33% 9.84% 15.89%
0.13,0.33]
Long/Short Equity 2.91 0.1735 [- 7.07% 6.97% 14.90%
0.16,0.57]
Tremont Managed 0.84 -0.4736 [-0.88,- 7.85% 7.60% 9.97%
Futures 0.07]
MSCI World Equity 0.35 -0.1828 [-0.36,- 8.51% 8.54% 12.54%
Index 0.03]
MSCI EU Equity Index 4.25 0.3146 [- 10.05% 10.24% 25.28%
0.07,0.70]
S&P 500 0.17 0.0250 [- 8.22% 8.64% 13.51%
0.29,0.30]
Lehman US Bond Index 0.20 -0.1083 [- 4.95% 4.88% 7.39%
0.37,0.16]
SSB Bond Index 0.47 0.0624 [- 3.60% 3.76% 6.39%
0.39,0.40]

Table 4: GPD model estimates for Tremont hedge fund indices and
traditional market indices (sample information).

In Table 4 we report the results of a tail study based on the basic GPD
model introduced above. The data base consists of monthly absolute
returns of the Tremont hedge fund style indices and some traditional

35
market indices for the time period from January 1994 to December 2002.
This makes 108 data points per index, which is rather few in absolute
terms, but a typical situation in view of the short histories and low
reporting frequencies prevalent in the hedge fund industry. The second
data column reports maximum likelihood estimates for the shape
parameter , complemented by related 90%-confidence intervals in the
next column. Selection of a suitable threshold employed graphical
evaluation techniques suggested by Embrechts et al.40, and by repeating
the estimation across a range of possible thresholds. We notice that the
confidence intervals are rather wide, which is not astonishing given the
low amounts of data at hand. For some of the indices we obtained
negative values for , indicating that the returns distributions follow
41
short-tailed law . For the other indices, the results suggest values of
above zero, i.e. heavy-tailed returns distributions, with particular
significance for the Fixed Income Arbitrage index. Notice also that the
excess kurtosis estimates correspond to the tail shape parameter
estimates; there is only low excess kurtosis for those indices where the
estimated suggests thin tails, whereas there is high excess kurtosis in
the case of highly positive values of . In the last three columns, we
report Value-at-Risk estimates for the 95% and 99.6% confidence levels.
For the former we have estimates from both the empirical distribution of
the data and the GPD model. We see that the two estimates correspond
relatively well with each other, with the GPD-based estimates being
generally more conservative, except for the cases where the estimated
negative suggests a capped distribution. The 99.6% level is beyond the
range covered by data, so we have to rely on the model entirely. Notice
also that the series with the heaviest tail (Tremont Fixed Income
Arbitrage) has the lowest outcomes on an absolute scale. Indeed,
"extreme values" in this context must always be thought of as extreme
with respect to the "usual" behavior of the risk factor, and not on an
absolute scale. This is further stressed by Table 5, where we restate the
VaR estimates as multiples of the standard deviation above the mean, i.e.
as the n in the equation VaR = + n , hereby relating VaR to the
classical volatility measures and removing the impact of location and
scale. We can clearly see that VaR increases much more dramatically
between the 95% level (not yet really in the tail) and the 99.6% level (far
out in the tail).

VaR 95% VaR

99.6%

40
Embrechts P., Klüpperberg C. and Mikosch T., Modelling Extremal Events for Insurance and Finance,
2nd edition, Springer Verlag, Berlin (1999);
41
It is not customary in finance to use capped (i.e. short-tailed) distributionsto model return
distributions, since there is always a potential – possibly very small – for extreme moves. Given a
negative estimate of , one would usually select a thin-tailed model ( ), e.g. the Gaussian one.
36
 Hedge Fund Index 0.89 2.56% - 1.95 2.95
% 0.2968
Convertible Arbitrage 0.82 1.40% 0.0828 1.55 3.20
%
Dedicated Short Bias 0.20 5.31% 0.2814 1.73 3.47
%
Emerging Markets 0.68 5.26% 0.2181 1.82 4.05
%
Equity Market Neutral 0.84 0.89% - 1.73 2.74
% 0.2606
Event Driven 0.85 1.81% 0.3105 1.39 3.48
%
Fixed Income 0.60 1.35% 0.3759 1.34 4.24
Arbitrage %
Global Macro 1.17 3.67% 0.1110 1.82 4.01
%
Long/Short Equity 0.97 3.32% 0.1735 1.81 4.20
%
Managed Futures 0.57 3.46% - 2.03 2.71
% 0.4736
MSCI World Equity 0.35 4.29% - 1.91 2.84
Index % 0.1828
MSCI Europe Equity 0.36 5.46% 0.3146 1.81 4.56
Index %
S&P 500 0.70 4.68% 0.0250 1.70 2.73
%
Lehman US Bond 0.74 2.43% - 1.70 2.74
Index % 0.1083
SSB Bond Index 0.50 1.83% 0.0624 1.65 3.09
%

Table 5: Value-at-Risk expressed in terms of mean and standard

deviation (sample information). A Gaussian factor would be 1.65 for 95%
and 2.65 for 99.6%.

The above example suggests that instruments with heavy-tailed return

distributions reside in both traditional and hedge fund markets, even on
time aggregations as high as monthly periods. Prudent risk management
requires the ability to test and account for this phenomenon. The
approach presented here is an easy-to-implement tool, which is in practice
well-proven in settings with low amounts of data and low inter-temporal
dependence. For further very useful methods applicable in more involved
settings, and related information, we refer to the more elaborate
publication by P. Blum, M. Dacorogna, and L. Jaeger. 42

42
P. Blum, M. Dacorgna, L. Jaeger, “ P. Blum, M. Dacorogna, L. Jaeger, “Performance and risk
measurement challenges for hedge funds: empirical considerations”, in L. Jaeger (ed.), “The New
Generation of Risk Management in Hedge Funds and Private Equity Investments”, Euromoney 2003.

37
Active risk management

Risk management is both an art and a science. While the later refers to
the more quantitative elements of risk measurement, the “art” of risk
management corresponds to wisdom and good judgment that the risk
manager develops over time. Risk measurement is an important element
of risk management, but in itself it remains a passive activity. In contrast,
risk management requires action and goes beyond risk measuring (but is
nevertheless based on accurate risk analysis). While risk measurement
aims at providing an objective assessment of how much risk is present in
the portfolio, risk management consists of a variety of other (sometimes
rather subjectively determined) factors. Active risk management entails
the dynamic and optimal allocation of risk among different assets and
managers. It consists of defining and enforcing risk limits, performing
dynamic portfolio allocation according to - possibly changing - risk
parameters, and accepting certain risk factors, but eliminating others that
are deemed unaccepted.

The very fact that hedge fund managers take risks is surely not
undesirable. However, risk that is unintended, misunderstood,
mismanaged or mispriced should not be accepted. Bearing these risks
consciously, the risk manager needs to able to take proactive step and
remedy critical situations quickly. When a crisis has arrived, it is often too
late to make adjustments. Within a framework of active hedge fund risk
management there are various ways to manage risk and exercise control
over trading managers.
• Risk Reporting: An important prerequisite for functioning risk
management is the appropriate reporting of risk to the portfolio
decision makers. The risk manager should ideally be directly involved
in this decision making process, e.g. by being a member in the
governing investment committee. The reports should contain the
relevant information but should not be a graveyard for numbers at
the same time. Figure 2 provides an example of a risk report for a
hedge fund portfolio.
• Regular conversations. The hedge fund investor/fund of funds
manager should frequently talk with managers about the current and
potential future risks of their trading strategy. He should know how
the individual manager judges his strategy’s current risk profile and,
based on his understanding of the strategy, develop his own view
about its vulnerability in given market conditions.
• Risk or exposure limits. The risk manager should distinguish
between risk levels and sources which are accepted, and those which
are not. He can define certain “risk budgets” on the level of the

38
 global portfolio, single asset class, strategy sector, or manager.
These are ceilings on the amount of acceptable risk as indicated by
measures such as VaR, notional exposure, leverage or simulated
stress test losses. The values should be dynamic rather than
statically fixed in accordance with the hedge fund manager and his
strategy (imposing unsuited limits on a manager will affect returns
negatively). Once predefined (and agreed) limits are exceeded, the
risk manager must undertake action ranging from discussion with the
manager to re-allocation or de-leveraging and in worst circumstances
to closure of positions or complete exclusion of the strategy from the
portfolio.
• Definition of stop-loss limits. The portfolio manager can set limits on
each manager’s maximal drawdown. The definition of such a limit
should depend on the strategy and should be made in consultation
with the manager before the allocation.
• Request for explanations about unusual positions. Unexpected and
unexplained high exposures to certain securities or asset classes or
unusual leverage factors should be immediately addressed. They are
warning signs for upcoming problems. If the manager does not
provide a convincing explanation for such exposures, the allocator
should force him to close the positions and consider excluding him
from the portfolio.
• Firing of managers with “issues”. Managers who have breached
certain agreements, are convicted of illegal or unethical behavior by
regulatory authorities, or take excessive single bets that do not
correspond to defined trading strategies, should be quickly excluded
from the portfolio.

VII. Current issues for Hedge Fund Risk Management

Arguments raised against transparency

Despite growing investor awareness of the importance of transparency
(i.e. position disclosure) and active risk management by selected
monitoring agents (e.g. fund of funds), there remains a surprising degree
of resistance to such transparency in the hedge fund industry. The
following three concerns are frequently expressed with respect to
transparency down to the position level:

1. Confidential position information reaches the market place

potentially causing the strategy either to lose its competitive edge, if
more players adopt the strategy, and/or to be actively traded
against by certain market players.
2. Investors lack the skill to evaluate the massive amount of
information provided by daily positions.

39
 3. The request for transparency will lead to the exclusion of the best
managers within the universe of hedge funds from the portfolio.

A reply to the transparency doubters

The three arguments against position transparency to selected
independent third parties presented shall be addressed in the following.

For the first argument, the author wants to emphasize that the argument
for transparency is by no means a pledge to provide every single investor
and the wide investing public access to confidential information about a
hedge fund manager’s trading activities. Hedge fund managers can set up
confidentiality and non-disclosure agreements with large investors and
fund of fund managers. As mentioned above transparency is possible (and
necessary) only for a small class of hedge fund portfolio managers such as
funds of funds. One must consider who actually poses a threat to Hedge
fund managers. The threat comes mostly from the dealer community and
the proprietary trading desks within the large investment banks (i.e. the
prime brokers) rather than from fund of funds managers or individual
investors.

The second argument neglects to take into account the increasing

expertise and capacity of some fund of fund managers. With the advent of
modern communication and data processing tools the handling of a large
set of information can be performed quite efficiently. A large variety of
tools and software packages for sophisticated risk management are now
available.

Sometimes the third argument is raised in combination with the statement

that the best managers are unwilling to provide transparency or insight
into their trading approach. Critics argue that hedge fund investors that
require transparency (e.g. through a managed account) necessarily have
to invest with lower performing managers. There are indeed some
managers with excellent performance track records who refuse to provide
any transparency to investors, but it is one of the persistent myths about
hedge funds that attractive returns are linked with a lack of transparency.
Examples of secretive, non-transparent and, for certain periods of time,
very successful strategies are LTCM, Quantum fund, Tiger and
Niederhoffer, all of which failed spectacularly in the end. Investors failed
to understand that high past returns were connected to high risks, which
eventually led to failure. The discussion on return sources of hedge funds
is essential for a better picture of their risks and thus illustrates that the
image secrecy and mystique that still surrounds hedge funds is largely
unjustified.

40
The belief that the best managers are necessarily non-transparent and
hedge fund portfolio managers focusing on transparency are therefore left
with “second tier” managers also does not find any empirical support. An
increasing number of managed account platforms have succeeded in
working with the best names of the industry. Many high quality managers
with excellent past track records are willing to offer the desired
transparency to the fund of fund manager, if certain requirements (same
efficiency in trading as in the manager’s own fund vehicle, confidentiality,
minimum size) are fulfilled. Inversely, managers who refuse to provide
transparency of their investment activities have a systematic
disadvantage: Lack of transparency means a significant higher risk to the
investor, which according to investor expectations subsequently requires a
higher return. But where should that return come from? It is not plausible
that performance should depend on the fact that a fund of fund manager
receives or does not receive disclosure of the manager’s activities.

Managed Accounts
The most effective way to address the need for both liquidity and
transparency as prerequisites of effective risk management is via a
managed account. The hedge fund investor/allocator (e.g. fund of funds)
sets up a separate account in which the hedge fund manager has a special
authority to execute his trading strategy, in most cases one-to-one as in
his fund. Managed accounts provide the hedge fund investor/allocator with
full disclosure of the managers’ trading activities together with a highest
possible degree of liquidity. Further, the investor/allocator is in a position
to select all involved counter-parties including the prime broker,
custodian, and auditor. All this creates the optimal basis for proactive risk
management.

Some object that managed account limits the amount (and quality) of
managers to be included in the Hedge fund portfolio. It is indeed difficult
to obtain a managed account with top managers if one does not fulfill the
following crucial criteria for an allocation:

1. A managed account requires the replication of the entire trading

infrastructure of a Hedge fund. The manager needs to be provided
the more or less identical environment in order to execute his
strategy efficiently and identically to his own fund. This is more
complex as it seems at first sight. One has to work with the prime
broker of the managers’ choice which can quickly lead to
relationships with a dozen different prime brokers with different
systems, conventions, etc. Further does the portfolio manager need
to provide the legal environment for the manager, in particular the
different ISDA swap agreement, legal representations (i.e. qualified
investor status), the prime brokerage agreement, etc. A managed

41
 account can require up to a dozen and more different legal
contracts. It is essential in order to convince high quality manager
to execute their strategy in a managed account to make his trading
and easy and as comfortable in the managed account as in his own
fund. In other words, he needs to have the car he is driving fully
equipped and filled with gas and reliable mechanics on the side. This
requires experience and a great deal of extra work by the portfolio
manager (fund of funds). Often, the a priori complaints of hedge
fund investors as well as fund of funds managers that the “top
quartile hedge fund managers are not available for managed
accounts” is based less on their actual experience with these hedge
funds but accounts rather for their inability and/or unwillingness to
install the necessary complexity in their own investment
infrastructure.
2. The portfolio has to be willing (and able) to provide the manager
with confidentiality agreements. The manager needs to be certain
that the proprietary information about his trading does not go
beyond the portfolio manager or fund of funds. The independence of
the portfolio manager from larger institution is a great benefit, as it
is more difficult for Hedge fund portfolio managers in banks and
other financial groups with their own proprietary trading desk to
ensure confidentiality43.
3. The Hedge fund allocator should be in a position to allocate a
significant amount of capital to the Hedge fund strategy. Managed
accounts often require a significant minimum investment of up to $
20 million.

Even with these requirements fulfilled, not all Hedge fund managers agree
to exercise their strategy via a managed account. But the number of these
managers is actually decreasing rapidly. Manager unwilling or unable to
work on a managed account basis most often represent particular strategy
sectors such as Distressed Securities, Reg D and the large Global Macro
tradersIt is increasingly considered a sign of quality even within the
community of Hedge fund managers themselves, if a managers offers
transparency with respect to his investment approach and trading
activities.

Transparency in the institutional context: The new role of funds of

funds
The author acknowledges that there is a natural conflict between the
investors’ need for information to perform an independent risk
management and the managers’ legitimate interest in keeping some of his
most sensitive positions secret to the wide public (a spread of this

43
Chinese walls are often less dense as they are claimed to be.

42
information can be quite harmful to the manager, this applies especially
with respect to short positions). It should be reiterated that the pledge for
transparency is by no means a request to provide every single investor
and the wide investing public access to confidential information about a
hedge fund manager’s trading activities. Transparency to the level of
position details is possible (and necessary) only for a small class of
investors, mostly the professional Hedge fund portfolio manager, e.g. the
fund of fund.

Realizing that insufficient independent risk management for hedge funds

is one of the key challenge of the industry, one can go further and
anticipate an important additional strategic roles funds of funds will play in
the future: acting as the independent risk manager on behalf of the
investors. Their role would be to resolve the conflict between the
legitimate managers’ interests for confidentiality and investors’ need for
information and independent risk management. The fund of funds
manager playing this intermediary role is probably the most promising
proposal for addressing the persistent investor concerns about hedge fund
risks.

It is important to note that besides position transparency, the fund of

funds manager needs a deep strategy understanding as well as the
appropriate procedural infrastructure to act on the obtained information
(i.e. adequate liquidity management). The challenges of hedge funds
(complexity and rapid change) require fund of funds operations with
highly specializes staff and strong commitment. The asset inflow to hedge
funds led to a proliferation of funds of funds many of which perhaps lack
the skill and resources to meet all these challenges at once, the dynamic
complexity of hedge funds and their risks as well as the efficient use of
position information for the purpose of risk control. It remains to be seen
whether existing funds of funds possess the will and the capability to
develop the necessary expertise to meet these challenges.

VII. Conclusion

The increasing demand for hedge funds from institutional investors and a
generally higher level of investor sophistication renders the “black box”
approach more and more unsuitable. The demand and need for
independent risk management is obvious, and the industry has to face the
challenges associated with this new type of investor demand. An
important prerequisite for implementing an independent risk management
infrastructure is transparency on the level of trading positions and
sufficient liquidity to react when necessary. Both can be most efficiently
achieved in a managed account set up. Fortunately the primary

43
instrument liquidity in hedge funds is relatively high which makes returns
little affected by shorter redemption periods.

Once the hedge fund risk manager is in a position to have the necessary
data made available to him, he can apply similar or even identical risk
analysis techniques as for any other asset class. In that respect his job is
comparable to the task of a risk manager in a proprietary trading
environment in an investment bank. This article provided some of the
more sophisticated analysis techniques discussed in the recent risk
management literature accounting specifically for the non-normal
distribution properties of hedge fund.

Active risk management can help to decrease the severity of investment

losses by avoiding accidents and investment disasters. But it has to be
noted, that risk management does not by itself lead to positive
performance, nor does it prevent losses under all circumstances. For each
investment there exist hostile market environments that will lead to the
strategy showing weak performance or losses. Risk management entails
the process of allocating and diversifying an acceptable level of
measurable risk across hedge fund strategies, assessing frequently
whether the risk limits are exceeded, and taking corrective measures if
deemed necessary. The author wishes to conclude by stressing that no
degree of transparency and no amount of quantitative analysis can
replace proper investment judgment.

A last note concerns the issue of regulation. There is increasing effort to

establish a ‘hedge fund’ regulation scheme to be enforced by international
monetary agencies. We believe that the increase in transparency and a
willingness to disclose positions to investors will diminish the urge for
regulation. A flexible risk management and control structure established
by the industry itself is surely more preferable than a rigid set of
regulations.

44
 Täglicher Risikobericht
per 28.11.2005 (basierend auf Daten vom 25.11.2005)

Alpha-Invest I

NAV Information Value at Risk (VaR) / Täglicher Gewinn/Verlust Konfidenzintervall: 99% Haltedauer: 1 Tag
NAV pro Anteil 1'014.95
1.20%
1. 20%
DZ-info-NET Eigengesch.-Angebot/Prod.-Eigenanlagefonds-Fondspreise

Reutersseite UIDZ01 1.00%

1. 00%

Bloomberg ALINV1I LX <Equity> <GO> 0.80%

0. 80%
Union-Online Fonds
0.60%
0. 60%

Risikokennzahlen per 31.10.2005 0.40%

0. 40%
VaR/P&L

Annualisierte Rendite 3.82%

0.20%
Volatilität 3.25% 0. 20%

Sharpe Ratio (rf: 2%) 0.56 0.00%

0. 00%
Korrelation zum EURO STOXX 50 -0.02
-0.20%
Korrelation zum MSCI World Index -0.03 - 0. 20%

Korrelation zum Citigroup World Government Bond Index -0.03 -0.40%

- 0. 40%
*basierend auf täglichen Daten seit Auflegung am 15.01.2003; monatlich aktualisiert -0.60%
- 0. 60%

Allokationsübersicht** / Allokationscharakteristika -0.80%

- 0. 80%
Sektorallokation Relative Value 7.32%
-1.00%
Equity Hedge 43.58% - 1. 00%

-1.20%
Futures Strategies 7.77%
Nov. 03

Nov. 04

Nov. 05
Mrz. 03

Mai. 03

Dez. 03

Mrz. 04

Mai. 04

Dez. 04

Mrz. 05

Mai. 05
Jan. 03

Feb. 03

Sep. 03
Okt. 03

Jan. 04

Feb. 04

Sep. 04
Okt. 04

Jan. 05

Feb. 05

Sep. 05
Okt. 05
Apr. 03

Jun. 03

Jul. 03

Aug. 03

Apr. 04

Jun. 04
Jul. 04

Aug. 04

Apr. 05

Jun. 05
Jul. 05

Aug. 05
- 1. 20%
Event Driven 18.37%
Global Macro 10.88%

Opportunistic 11.06% VaR basierend auf Portfoliodaten vom 25.11.2005 (Konfidenzintervall 99% / Haltedauer 1 Tag) 0.84%

Cash / Money Market 1.02%

Merger Arbitrage Long Exposure 134.78% Stress Test Analyse (bezüglich täglichem Gewinn/Verlust)*
Netto Exposure 82.77%
Größte Einzelposition 6.85% Aktien-, Devisen- und Rohstoffmärkte -10% -5% +5% +10%

Convertible Arbitrage Adjusted Credit Exposure 4.79% Aktienmarktbewegung -3.77% -1.82% 1.75% 3.44%

Leverage 1.92 USD Bewegung gegen ein Devisenportfolio ** -0.71% -0.36% 0.36% 0.72%

Größte Einzelposition 8.58% Preisveränderung eines Rohstoffportfolios -0.50% -0.25% 0.25% 0.50%

Long / Short Equity Brutto Exposure 155.90% Zinsmärkte* -50bp -25bp +25bp +50bp

Netto Exposure 74.39% Parallel-Verschiebung Zinskurven -1.43% -0.73% 0.75% 1.50%

Größte Einzelposition 2.11% Veränderung der Kredit-Risikoprämie 0.42% 0.21% -0.20% -0.39%

Equity Market Neutral Brutto Exposure 427.13% Historische Szenarienanalyse

Netto Exposure -1.32% 11. September 2001 (5 Tage) -3.97%

Größte Einzelposition 8.29% Russische Finanzkrise August 1998 (5 Tage) -4.72%

Futures Margin To Equity (MTE) Total 7.70%

* Erklärungen und Beispiele zur Stress Test Analyse: -> Eine Bewegung der Aktienmärkte um -10% resultiert nach dieser Berechnung in einer Veränderung
Anteil MTE Rohstoffe 38.78% des Alpha-Invest NAVs von -3.77%. -> Eine parallele Bewegung der Zinskurven um +50bp resultiert nach dieser Berechnung in einer Veränderung des Alpha-
Invest NAVs von 1.50%. -> Eine Wiederholung der Bewegung an den Finanzmärkten nach dem 11. September 2001 resultiert nach dieser Berechnung in
Anteil MTE Aktien 12.33% einer Veränderung des NAVs von -3.97%.

Anteil MTE Währungen 27.23%

** Nicht berücksichtigt sind unrealisierte Gewinne und Verluste aus Devisentermingeschäften. Deswegen kann die Summe von 100% abweichen.
Anteil MTE Renten 21.66%

VaR Analyse: Aufteilung nach Anlagekategorien VaR Analyse: Aufteilung nach Manager
1.00%
0.250%

0.90%

0.80% 0.200%

0.70%

0.60% 0.150%

0.50%

0.100%
0.40%

0.30%

0.050%
0.20%

0.10%
0.000%
LS Equity

LS Equity

LS Equity

LS Equity

22-Nov-2005
LS Equity

LS Equity

0.00%
LS Equity

LS Equity

EMN

EMN

EMN
Nov. 03

Nov. 04

Nov. 05
Mrz. 03

Dez. 03

Mrz. 04

Dez. 04

Mrz. 05
Jan. 03
Feb. 03

Apr. 03
Mai. 03
Jun. 03
Jul. 03
Aug. 03
Sep. 03
Okt. 03

Jan. 04
Feb. 04

Apr. 04
Mai. 04
Jun. 04
Jul. 04
Aug. 04
Sep. 04
Okt. 04

Jan. 05
Feb. 05

Apr. 05
Mai. 05
Jun. 05
Jul. 05
Aug. 05
Sep. 05
Okt. 05

EMN

24-Nov-2005
Merger Arb

Convertible Arb.

Convertible Arb.

Global Macro

Global Macro

Futures/CTA

Futures/CTA

28-Nov-2005
Futures/CTA

Futures/CTA

Spec Sit

Spec Sit

Spec Sit

Opportunistic

Opportunistic

Opportunistic

Commodity Risk Fixed Income Risik FX Risk Equity Risk

Korrelation Korrelation beschreibt den linearen Zusammenhang zwischen zwei Variablen und nimmt einen W ert zwischen -1 und 1 an. Beispiel: eine Korrelation von 0.95 zwischen einem Long/Short Hedge Fund und dem NASDAQ Index bedeutet eine starke Abhängigkeit in der
Bewegung der zwei Variablen (praktisch synchrones Verhalten).

Exposure Exposure stellt den im Markt investierten Vermögensbetrag dem Gesamtvermögen des Fonds gegenüber, gemessen in Prozent.

Hedge Ratio Hedge Ratio setzt den aggregierten W ert aller "short" ("long") Positionen in Aktien oder Derivaten, die ins Portfolio integriet wurden, um entsprechende "long" ("short") Positionen in W andelanleihen abzusichern, ins Verhältnis zum aggregierten Wert dieser "long" ("short")
Positionen, gemessen in Prozent.

Leverage Leverage beschreibt die Verwendung von verschiedenen Finanzinstrumenten oder die Aufnahme von Fremdkapital, die zwecks der Erhöhung der Rendite eingesetzt werden. Leverage kann durch die Verwendung von Optionen, Futures, Margenkäufen oder anderer
Finanzinstrumente geschaffen werden. Ein höheres Leverage Verhältnis führt zu einer höheren Renditeerwartung, allerdings bei ebenfalls erhöhtem Risiko.

Margin to Equity Margin (Sicherheitsmarge) entspricht dem Kapital, das beim Kauf oder Leerverkauf eines Finanzinstrumentes (z.B. Terminkontraktes/Futures) zur Absicherung des Gegenparteirisikos hinterlegt werden muss. Das Margin to Equity (MTE) Verhältnis wird durch die
Multiplikation des Investitionsverhältnisses mit dem Gesamtbetrag der Initial Margins (erstmalige Hinterlegung) berechnet und in Prozenten des NAV der entsprechenden Zelle ausgewiesen.

Standardabweichung Die Standardabweichung ist ein statistisches Maß zur Messung der Streuungsbreite. So kann mittels der Standardabweichung beispielsweise die Streuung von Renditen einer Investition um die erwartete Rendite gemessen werden. Partners Group verwendet monatliche
Renditen für die entsprechenden Berechnungen.

Sharpe Ratio / rf Sharpe Ratio ist ein Maß zur Bestimmung der erwirtschafteten Mehrrendite. Dieses dividiert die Mehrrendite gegenüber einer risikofreien Anlage durch die Volatilität des Portfolios. Partners Group unterstellt dabei einen risikofreien Zinssatz (rf) von 2.0% und verwendet
monatliche Renditen.

Stress Test Stress Tests zeigen das Verhalten eines Porfolios unter bestimmten extremen Marktszenarien auf. Sie dienen als Ergänzung zur VaR-Analyse: Während VaR das Risiko von Ereignissen in normalen Marktumgebungen misst, zeigen Stress Tests das Verhalten des Portfolios
bei Ereignissen in volatilen Marktumfeldern auf.

Value at Risk (VaR) VaR ist in der Finanzindustrie die am häufigsten verwendete Meßgrösse zur Quantifizierung von Risiko. VaR ist definiert als die Höhe desjenigen Maximalverlustes, der mit einem bestimmten Konfidenzintervall innerhalb eines bestimmten Zeithorizontes nicht überschritten
wird. Partners Group berechnet VaR mit Hilfe von Monte Carlo-Simulationen und jeweiliger vollständiger Neubewertung aller Instrumente. Konfidenzintervall: 99% / Zeithorizont: 1 Tag

Hinweis: Dieser Bericht bezieht sich auf das Gesamtportfolio aus Alpha-Invest und Unico AI Multi-Hedge Strategy. Bei den Fondskennzahlen, vor allem bei der Angabe der Fondszusammensetzung, können in den laufenden Berichten
im Vergleich zu den maßgeblichen Angaben des Rechenschaftsberichtes zeitweise in geringfügigem Maße technisch bedingte Abweichungen auftreten. Er beschreibt historische Daten und kann dementsprechend nicht als Garantie für
zukünftige Entwicklungen verstanden werden. Die Daten in diesem Risikoreport werden von Partners Group als sinnvoll und richtig erachtet. Nichtsdestotrotz gibt Partners Group keine Garantie ab, explizit oder implizit, dass die
vorliegenden Daten, vollständig und richtig sind, ebenso wird keine Haftung übernommen für Schäden, welche vermeintlich durch Informationen aus diesem Risikoreport entstanden sind. Angaben in diesem Bericht sind nicht als Angebot
oder Empfehlung zum Kauf oder Verkauf von Anteilen des Alpha-Invest zu verstehen. Alle Angaben, Daten und Berechnungen dieses Dokuments wurden von Partners Group zur Verfügung gestellt und dienen ausschließlich
Informationszwecken. Die UNICO Asset Management S.A. hat diese Angaben nicht geprüft. Sie übernimmt für die Richtigkeit und für die Verwendung der Angaben, Daten und Berechnungen keine Haftung. 45
Figure 2: Example for a daily risk report (for an existing product: Alpha Invest/ Union
Investment)

46